Simpler energy tariffs will lead to higher bills and less competition

Stephen Littlechild is fellow at Judge Business School, University of Cambridge, emeritus professor at the University of Birmingham, and was the UK electricity regulator between 1989 and 1998.

Stephen Littlechild

THE Prime Minister has proposed that each energy supplier should put all its customers on the best tariff. The regulator Ofgem has proposed that suppliers should be restricted to four tariffs each. The Department for Energy and Climate Change has proposed putting a mix of these proposals into law. Has no one thought through the consequences?

These ideas are based on a simple economic fallacy: that the range of tariffs available in a competitive market would remain unchanged if new obligations were introduced. It would not. If a supplier were required to put all its customers on its best tariff, it would simply withdraw that “best” tariff.

To illustrate, the average annual dual fuel bill is about £1300 and the cheapest dual fuel tariff about £1165 – a difference of £135. Roughly 75 per cent of customers are on standard tariffs and 25 per cent on cheaper ones. Consider a major supplier with 3m customers on standard tariffs and 1m customers on cheaper ones. Which would be more profitable: to cut prices by £135 to 3m customers, at a loss of revenue of £405m per year, or to withdraw the cheap tariffs and lose 1m customers of only borderline profitability? This is a no-brainer.

Such proposals are effectively a tax on competition. They would drive the lowest prices out of the market. Over time this reduction in competitive pressure would increase prices and profit margins across the board. All customers would be worse off, including those the policy is designed to help.

The proposal that each supplier should be allowed only four tariffs is particularly repressive. Many tariff options and discounts would be reduced, withdrawn or prohibited. Under pressure from Ofgem, some of the major suppliers have already moved in this direction, and retail profit margins are already increasing.

The proposals have no counterbalancing advantages. The only potential beneficiaries would be the major energy suppliers, which would be able to enjoy quieter and more profitable lives, unhindered by retail competition.

There would be other negative consequences. These proposals would considerably increase the cost of regulation – though Ofgem says it does not know what this cost would be. Its argument for change runs to 700 pages. It proposes 80 pages of additional license conditions. In terms of UK red-tape regulatory bureaucracy, this is the biggest step backwards in 30 years. Disputes over interpretation would be rife.

Restrictions on the number and type of tariffs would effectively preclude innovation. A supplier could only introduce a new tariff if it withdrew one of its four existing ones. What sane company would sacrifice a quarter of its existing sales to bet on an uncertain new product? New entrants would suffer too – they would be prevented from offering a range of niche products to compete with the high-volume incumbent suppliers. And Ofgem’s provisions for exceptions and derogations invite lobbying, political influence and worse.

The longer-term consequences are even more serious. When such policies deliver less competition rather than more, and higher prices rather than lower, is it likely that the government will repeal them? More likely, it will say that the policies did not go far enough. There will be a demand for direct controls on profit margins, on wholesale transfer prices and on final retail prices. And if a competitive market has failed so comprehensively, what is the case for continued private ownership? But without competition and private ownership, will a nationalised monopoly have the ability and incentive to purchase efficiently on the wholesale energy market? Are taxpayers ready to fund the £200bn future energy investment programme that the government envisages?

There are strong and understandable concerns about high and rising energy prices. But competition (or the alleged lack of it) in the retail energy market is not the source of the problem. The causes of price increases lie in international wholesale gas markets, in the costs of low-carbon generation, environmental regulation and other government and EU policies. We should explicitly explain and discuss these costs, instead of shooting the messenger.

Stephen Littlechild is fellow at Judge Business School, University of Cambridge, emeritus professor at the University of Birmingham, and was an energy regulator between 1989 and 1998.